[Federal Register Volume 66, Number 72 (Friday, April 13, 2001)]
[Notices]
[Pages 19268-19271]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-9148]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44165; File No. SR-NASD-2001-27]


Self-Regulatory Organizations: Notice of Filing and Order 
Granting Accelerated Approval of a Proposed Rule Change by the National 
Association of Securities Dealers, Inc. Relating to Customer Limit 
Order Protection in a Decimal Trading Environment

April 6, 2001.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(Act) \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that on 
April 6, 2001, the National Association of Securities Dealers, Inc. 
(NASD or Association), through its subsidiary, the Nasdaq Stock Market, 
Inc. (Nasdaq), filed with the Securities and Exchange Commission 
(Commission or SEC) the proposed rule changes as described in Items I 
and II below, which Items have been prepared by Nasdaq. The Commission 
is publishing this notice to solicit comments on the proposed rule 
change from interested persons. As discussed below, the Commission is 
granting accelerated approval of the proposed rule change for a pilot 
period until July 9, 2001.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    Nasdaq proposes to moidfy NASD Interpretative Material 2110-2--
Trading Ahead of Customer Limit Order (Manning Interpretation or 
Interpretation) for securities priced in decimals. Nasdaq will 
implement this rule change immediately upon approval. The text of this 
rule change is provided below. Proposed new language is italicized and 
deleted language is in brackets.

IM-2110-2. Trading Ahead of Customer Limit Order

(3) No Change. General Application
    To continue to ensurer investor protection and enhance market 
quality, the Association's Board of Governors is issuing an 
interpretation to the Rules of the Association dealing with member 
firms' treatment of their customer limit orders in Nadsaq securities. 
This interpretation, which is applicable from 9:30 a.m. to 6:30 p.m. 
Eastern Time, will require members acting as market makers to handle 
their customer limit orders with all due care so that market makers do 
not ``trade ahead'' of those limit orders. Thus, members acting as 
market makers that handle customer limit orders, whether received from 
their own customers or from another member, are prohibited from trading 
at prices equal or superior to that of the limit order without 
executing the limit order. Such orders shall be protected from 
executions at prices that are superior but not equal to that of the 
limit order. In the interests of investor protection, the Association 
is eliminating the so-called disclosure ``safe harbor'' previously 
established for members that fully disclosed to their customers the 
practice of trading ahead of a customer limit order by a market-making 
firm.
    Rule 2110 of the Association's Rules states that: A member, in the 
conduct of his business, shall observe high standards of commercial 
honor and just and equitable principals of trade.
    Rule 2320, the Best Execution Rule, states that: In any transaction 
for or with a customer, a member and persons associated with a member 
shall use reasonable diligence to ascertain the best inter-dealer 
market for the subject security and buy or sell in such a market so 
that the resultant price to the customer is as favorable as possible to 
the customer under prevailing market conditions.

Interpretation

    The following interpretation of Rule 2110 has been approved by the 
Board: A member firm that accepts and holds an unexecuted limit order 
form its customer (whether its own customer or a customer of another 
member) in a Nasdaq security and that continues to trade the subject 
security for its won market-making account at prices that would satisfy 
the customer's limit order, without executing that limit order, shall 
be deemed to have acted in a manner inconsistent with just and 
equitable principles of trade, in violation of Rule 2110, provided 
that, until September 1, 1995, customer limit orders in excess of 1,000 
shares received from another member firm shall be protected from the 
market maker's executions at prices that are superior but not equal to 
that of the limit order, and provided further, that a member firm may 
negotiate specific terms and conditions applicable to the acceptance of 
limit orders only with respect to limit orders that are: (a) for 
customer accounts that meet the definition of an ``institutional 
account'' as that term is defined in Rule 3110(c)(4); or (b) 10,000 
shares or more, unless such orders are less than $100,000 in value. 
Nothing in this interpretation, however, requires members to accept 
limit orders from any customer.
    By rescinding the safe harbor position and adopting this 
interpretation, the Association wishes to emphasize that members may 
not trade ahead of their customer limit orders in their market-making 
capacity even if the member had in the past fully disclosed the 
practice to its customers prior to accepting limit orders. The 
Association believes that, pursuant to Rule 2110, members accepting and 
holding unexecuted customer limit orders we certain duties to their 
customers and the customers of other member firms that may not be 
overcome or cured with disclosure of trading practices that include 
trading ahead of the customer's order. The terms and conditions under 
which institutional account or appropriately sized customer limit 
orders are accepted must be made clear to customers at the time the 
order is accepted by the firm so that trading ahead in the firm's 
market making capacity does not occur. For purposes of this 
interpretation, a member that controls or is controlled by another 
member shall be considered a single entity so that if a customer's 
limit order is accepted by one affiliate and forwarded to another 
affiliate for execution, the firms are considered a single entity and 
the market making unit may not trade ahead of that customer's limit 
order.
    As outlined in NASD Notice to Members 97-57, the minimum amount of 
price improvement necessary in order for a market maker to execute an 
incoming order on a proprietary basis when holding an unexecuted limit 
order for a Nasdaq security trading in fractions, and not be required 
to execute the held limit order, is as follows:
     If actual spread is greater than \1/16\ of a point, a firm 
must price improve an incoming order by at least a \1/16\. for stocks 
priced under $10, (which are quoted in \1/32\ increments) the firm must 
price improve by at least \1/64\.
     If actual spread is the minimum quotation increment, a 
firm must price

[[Page 19269]]

improve an incoming order by one-half the minimum quotation increment.
    For Nasdaq securities authorized for trading in decimals pursuant 
to the Decimals Implementation Plan For the Equities and Options 
Markets, the minimum amount of price improvement necessary in order for 
a market maker to execute an incoming order on a proprietary basis in a 
security trading in decimals when holding an unexecuted limit order in 
that same security, and not be required to execute the held limit 
order, is [$0.01.] as follows:
    (1) For customer limit orders priced at or inside the best inside 
market displayed in Nasdaq, the minimum amount of price improvement 
required is $0.01; and
    (2) For customer limit orders priced outside the best inside market 
displayed in Nasdaq, the market maker must price improve the incoming 
order by executing the incoming order at a price at lease equal to the 
next superior minimum quotation increment in Nasdaq (currently $0.01).
    The Association also wishes to emphasize that all members accepting 
customer limit orders owe those customers duties of ``best execution'' 
regardless of whether the orders are executed through the member's 
market making capacity or sent to another member for execution. As set 
out above, the Best Execution Rule requires members to use reasonable 
diligence to ascertain the best inter-dealer market for the security 
and buy or sell in such a market so that the price to the customer is 
as favorable as possible under prevailing market conditions. The 
Association emphasizes that order entry firms should continue to 
routinely monitor the handling of their customers' limit orders 
regarding the quality of the execution received.
    (b) No Change.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, Nasdaq included statements 
concerning the purpose of, and basis for, the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. Nasdaq has prepared summaries set forth in Sections A, 
B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    NASD's Manning Interpretation requires NASD member firms to provide 
a minimum level of price improvement to incoming orders in NMS and 
SmallCap securities if the firm chooses to trade as principal with 
those incoming orders at prices superior to customer limit orders they 
currently hold. If a firm fails to provide the minimum level of price 
improvement to the incoming order, the firm must execute its held 
customer limit orders. Generally, if a firm fails to provide the 
requisite amount of price improvement and also fails to execute its 
held customer limit orders, it is in violation of the Manning 
Interpretation.
    On March 2, 2001, the Commission approved on a pilot basis Nasdaq's 
proposal to establish a uniform $0.01 price improvement standard for 
market makers (``MMs'') who elect to execute proprietary transactions 
in securities priced in decimals while holding customer limit orders on 
the same side of the market in those securities without triggering an 
obligation to ``protect'' (i.e., execute, up to the amount of shares 
traded proprietarily by the MM) those customer orders.\3\
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    \3\ Securities Exchange Act Release No. 44030 (march 2, 2001), 
66 FR 14235.
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    Recently, Nasdaq has been made aware of certain anomalies that 
occur under its current Manning rule when MMs elect to provide their 
customers the ability to enter orders into the firm's proprietary 
system in price increments smaller than a penny. The following example 
illustrates the issue:

Example 1

Market is 10.00 to 10.01
MM has accepted a customer limit order to buy 100 shares at 9.994
MM then buys 1,000 shares on a proprietary basis at 10.00.\4\
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    \4\ Nasdaq notes that the Manning pricing anomalies described in 
this filing are equally applicable to MM's who do not affirmatively 
trade in front of customer orders, but instead merely have their 
displayed quotes accessed by other market participants. If allowed 
to continue, the impact of these pricing anomalies could be 
exacerbated by the future expansion of automatic-execution 
capabilities.

    As stated above, under Nasdaq's current Manning rule, the MM must 
protect limit orders within $0.01 if the price at which it trades 
(10.00) on a proprietary basis for up to 1,000 shares (i.e., the total 
size of the MM's proprietary trade). In this example, therefore, the MM 
would be obligated to execute the customer's limit order at 9.994 as 
well as all other customer limit orders to buy it has accepted that are 
priced at or between 10.00 to 9.991, up to a total of 1,000 shares.\5\
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    \5\ A firm that executes in front of customer limit orders that 
are owed Manning protection is obligated to only fill such limit 
orders for a total amount of shares equal to the number or shares 
traded proprietary by the firm. NASD's Notice to Members 95-43 (June 
1995).
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    This result has raised significant negative comment from market 
participants who assert that if Nasdaq's Manning rule remains as 
currently formulated, it will force them to engage in an increasing 
number of unprofitable trades (e.g., buy 1000 shares at 10 proprietary 
and be immediately obligated to sell to a total 1000 shares under 
Manning to a customer at 9.994). For example, a market maker may 
receive numerous customer limit but orders priced at just under a penny 
away from the inside bid and subsequently receive a market order 
directed to its posted best bid (or it may execute a trade at the best 
bid based on an understanding that it will provide its customers the 
best displayed price in Nasdaq), and then automatically be obligated 
under Manning to execute those limit orders priced outside the current 
inside spread, thereby consistently and unavoidably trading at a loss. 
In particular, market participants are concerned about electronic 
gaming of this pricing anomaly that could lead to significant monetary 
losses. For example, a single customer could electronically enter a 
series of limit orders into an MM's system priced outside the current 
market, but within one penny from the best market bid, and then 
subsequently enter a market sell order directed to that same MM. The 
resulting execution of the market order by the MM would in turn trigger 
a Manning obligation to that same customer's previously-entered limit 
orders resulting in the customer being able to automatically, and 
without risk, profit from the difference between the market price at 
which the customer sold to the MM and the price the MM is obligated to 
give the customer's limit orders. This concern is now at its most acute 
based on the upcoming full-implementation of decimal pricing for the 
entire Nasdaq market that will commence on Monday, April 9, 2001.
    For these reasons, Nasdaq has determined to propose modifying its 
current Manning Interpretation. Under the proposal, Nasdaq would 
maintain a strict $0.01 price improvement requirement for an MM wishing 
to trade proprietarily in front of its held customer limit orders that 
are priced at

[[Page 19270]]

or inside the current best inside market displayed in Nasdaq. For 
customer limit orders priced outside the inside spread, however, Nasdaq 
proposes to adopt a different standard. This standard would require an 
MM seeking to trade in front of such limit orders, without triggering a 
Manning obligation, to execute its proprietary trades at a price at 
least equal to the next displayable minimum quotation increment in 
Nasdaq (currently a penny) superior to those customer limit orders.\6\ 
The following examples illustrate how the proposed rule would operate:
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    \6\ Pursuant to the terms of the Decimals Implementation Plan 
(Implementation Plan), submitted to the Commission on July 24, 2000, 
the minimum quotation increment for Nasdaq securities (both National 
Market and SmallCap) at the outset of decimal pricing is $0.01. As 
such, Nasdaq will only display priced quotations to two places 
beyond the decimal point (to the penny). Quotations submitted to 
Nasdaq that do not meet this standard will be rejected by Nasdaq 
systems. See SR-NASD-01-07; Securities Exchange Act Release No. 
43876 (January 23, 2001), 66 FR 8251.

Example 2

Market is 10.00 to 10.01 with MM's posted bid and offer at the 
inside
MM receives and accepts Customer #1's limit order to buy priced at 
10.004 for 2000 shares
MM receives a market sell order directed to its posted bid of 10.00 
for 1000 shares and immediately executes that order on a proprietary 
basis

    In this example, since MM has executed within $0.01 of Customer 
#1's inside-the-spread buy limit order of 10.004, the MM would be 
obligated to protect that order and execute 1000 shares of Customer 
#1's order at a price of 10.004. As before, if the MM wishes to avoid a 
Manning obligation to Customer #1's 10.004 buy limit order, MM would 
have to execute its proprietary trade at a price at least $0.01 better 
than that limit order and execute at 10.014.

Example 3

Market is 10.00 to 10.01 with MM's posted bid and offer at the 
inside
MM receives and accepts Customer #2's limit order to buy priced at 
9.993 for 500 shares
MM receives a market sell order directed to its posted bid of 10.00 
for 700 shares and immediately executes that order on a proprietary 
basis

    Under the proposed amendment to the Interpretation, since the MM's 
700 share proprietary execution was done at a price (10.00) that is at 
least equal to the next superior penny minimum Nasdaq quotation 
increment to Customer #2's 9.993 outside-the-spread order, it would not 
be obligated to execute that limit order. Similarly, if the market 
remained at 10.00 to 10.01 and MM held a customer limit order to sell 
priced at 10.016, MM could trade proprietarily with an incoming buy 
order without triggering a Manning obligation to the 10.016 outside-
the-spread limit order if the MM executes its proprietary trade at a 
price of at least 10.01.
    Nasdaq believes that the proposed rule change draws an appropriate 
balance between providing effective limit order protection for 
customers who aggressively seek to participate in trading at the inside 
market while reducing the incidence of forced training losses to market 
makers who, in meeting their firm quote and best-execution obligations 
to other market participants, trade near customer limit orders which 
are priced outside the spread.
    As they have throughout the phased-in implementation of decimal 
pricing in the Nasdaq market, Nasdaq and NASD Regulation will closely 
monitor the protection of customer limit orders during the period after 
the full implementation of decimal pricing and will continue to analyze 
and evaluate trading activity to determine if future changes to the 
Manning price improvement standard are warranted.
2. Statutory Basis
    Nasdaq believes that the proposed rule change is consistent with 
Section 15A(b)(6) of the Act \7\ in that it is designated to promote 
just and equitable principles of trade; to foster cooperation and 
coordination with persons engaged in regulating, clearing, settling, 
and processing information with respect to, and facilitating 
transactions in securities; to perfect the mechanism of a free and open 
market and a national market system; and to protect investors and the 
public interest.
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    \7\ 15 U.S.C. 78o-3.
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B. Self-Regulatory Organization's Statement on Burden on Competition

    Nasdaq does not believe that the proposed rule change will result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants or Others

    Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the publication of this notice in the Federal 
Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organizations consent, the Commission will:
    A. By order approve such proposed rule change, or
    B. Institute proceedings to determine whether the proposed rule 
change should be disapproved.
    Nasdaq has requested accelerated approval of the proposed rule 
change pursuant to Section 19(b)(2) of the Act,\8\ submitting that the 
trading anomalies described in the filing could have a significantly 
impact on market activity and that accelerated approval will allow NASD 
firms an opportunity to reprogram their systems prior to, or 
contemporaneously with, the full implementation of decimal pricing in 
the Nasdaq market scheduled for Monday, April 9, 2001.
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    \8\ 15 U.S.C. 78s(b)(2).
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IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-
0609. Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of NASD. 
All submissions should refer to the File No. SR-NASD-2001-27 and should 
be submitted by May 4, 2001.

[[Page 19271]]

V. Commission Findings and Order Granting Partial Accelerated 
Approval of the Proposed Rule Change for a Pilot Period

    The Commission finds that the proposed rule change is consistent 
with the Act and the rules and regulations promulgated thereunder.\9\ 
Specifically, the Commission finds that approval of the proposed rule 
change is consistent with Section 15A(b)(6) of the Act.\10\
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    \9\ In granting accelerated approval of the proposal, the 
Commission has considered the proposal's impact on efficiency, 
competition, and capital formation. 15 U.S.C. 78c(f).
    \10\ 15 U.S.C. 78o-3(b)(6).
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    The Commission believes the proposed amendment to the Manning 
Interpretation should provide protection to customer limit orders in a 
subpenny trading environment by ensuring that such orders will continue 
to have access to market liquidity ahead of market makers in 
appropriate circumstances.\11\ However, we believe that the amendment 
should be reexamined once Nasdaq decimal trading behavior can be 
analyzed. As a result, the Commission is approving the amendment on a 
pilot basis through July 9, 2001. Nasdaq must submit to the Commission 
trade data related to the pilot on a monthly basis in order to allow 
the Commission to monitor the effect of the pilot on Nasdaq trading. 
Such information will include reported volume of orders received and 
executed in subpenny increments (in terms of both trades and shares), 
the execution price points, and the nature of the subpenny orders 
received and executed (i.e., agency, proprietary, professional or 
otherwise). Requiring this data does not alleviate the NASD of its 
obligations to provide any other reports required to be submitted to 
the Commission as part of its conversion to decimal pricing.\12\ The 
Commission will examine the data provided pursuant to this order, and 
other information provided by all self-regulatory organizations as 
required by the Implementation Plan. As a part of that examination, the 
Commission intends to reconsider the amendment to the Interpretation 
provided in this order.
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    \11\ As noted in the Interpretation, members accepting customer 
limit orders continue to owe those customers duties of ``best 
execution,'' i.e., a duty to use reasonable diligence to ascertain 
the best inter-dealer market for the security and buy or sell in 
such a market so that the price to the customer is as favorable as 
possible under prevailing market conditions.
    \12\ Specifically, NASD has agreed, pursuant to the 
Implementation Plan, to perform a detailed statistical analysis of 
quoting and trading activity that will be used to form the basis for 
a study or studies on systems capacity, liquidity, and trading 
behavior, including an analysis of whether there should be a uniform 
minimum trading increment. This report is required to be delivered 
to the Commission no later than 60 days after the full 
implementation of decimals. Securities Exchange Act Release No. 
42914 (June 8, 2000), 65 FR 38010.
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    The Commission finds good cause for granting Nasdaq's request for 
approval of the proposed rule change on a pilot basis prior to the 
thirtieth day after the date of publication of notice of filing thereof 
in the Federal Register. The Commission notes that the completion of 
Nasdaq's decimal transition will occur on April 9, 2001, at which point 
market makers will be subject to accepting and executing orders in 
subpenny increments for all Nasdaq securities. The Commission believes 
that granting accelerated approval to the proposed rule change will 
allow Nasdaq to continue to provide protection to customer limit orders 
when trading in subpenny increments for all Nasdaq securities begins.
    It is Therefore Ordered, pursuant to Section 19(b)(2) of the 
Act,\13\ that the proposed rule change (File No. SR-NASD-2001-27) is 
approved on a pilot basis until July 9, 2001.
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    \13\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\14\
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    \14\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-9148 Filed 4-12-01; 8:45 am]
BILLING CODE 8010-01-M